Covered bonds aren’t in the capital stack
Given that covered bonds have been carved out of bank resolution, should they still be considered a part of bank credit? Investors should think about redrawing their credit lines to distinguish between state-supported and bail-in debt.
Right now, the credit lines that investors have for any given institution typically include covered bonds along with all other forms of unsecured debt issued by the same lender. These lines are capped by an overall credit limit to the country of the issuer.
But this approach to credit does not work when covered bonds are so far outside the usual bank-sovereign loop.
The sovereign crisis in Greece illustrated that the expected recovery on a covered bond will be higher than on a government bond from the country of origin. Covered bond investors not only have recourse to a ring-fenced pool of collateral with a substantial loss absorbency cushion, but a prescribed recovery regime dictated by statute law.
In contrast, there is no collateral backing sovereign bonds and, in the event of its default, the government of the day will decide who and when it will repay, if at all.
Since the Greek bailout, peripheral covered bonds have proved much less volatile than their respective sovereign market. And, when sovereign markets have been distressed, covered bonds have traded at spreads deeply inside their government.
More important than the collateral is the confirmation that covered bonds will be outside bank resolution. While other bank liabilities are being dragged kicking and screaming into the new bail-in reality – with rating downgrades and lower expected recoveries – covered bonds are excluded from resolution. Since they will not be written down, recovery becomes a function of the price of underling assets, and since most programmes are highly overcollateralised and backed by a pool of low LTV mortgages, the probability of a loss is remote.
The meltdown of Banco Espirito Santo showed just how much better the covered bond fared. Investors in BES’s subordinated debt will suffer heavy losses, investors in its senior debt should get par, but with a heavy dose of market to market volatility. BES’s only outstanding covered bond sold off a little, but was far less volatile than other BES debt. Furthermore, covered bond investors reported that they could transact without having to pay too much of a liquidity premium compared to the other asset classes.
The only thing that keeps covered bond investors awake at night is a lack of covered bonds, not their risks. So why apply limits designed for senior debt to the product?